I. Inflation Targeting In Monetary Policy
An inflation target policy is utilized when a central bank announces an objective for the inflation rate, usually in a time line of one to three years.[1]
A. Central Banks and Inflation Targeting
Inflation targeting has only been around for twenty years, allowing many to still speculate on the beneficial effects of such a policy. There are many distortions as to whether or not a particular central bank is explicitly enforcing inflation targeting or applying the same procedures required under inflation targeting, but simply call it another name. There never is an exact number of countries that employ inflation targeting as many more central banks begin to adopt the policy or consider adopting it.[2] This section gives a brief overview of a few countries that have implemented inflation targeting and their experience with the policy thus far. The first section provides an overview of how banks practice explicit inflation targeting and their respective results, followed by an overview of central banks practicing implicit inflation targeting. Below is a list of central banks currently employing an explicit inflation targeting monetary policy.
[3]
The graph above gives an example of a few countries, both advanced and emerging, that currently implement an inflation target. It depicts the range in which they let it sit in, or, in the case of some, the point target they are trying to achieve. In the next section, we will discuss the implementation of an inflation target in various countries, both advanced and emerging, as well as those that implement an in implicit target.
Industrial Economies and Explicit Inflation Targeting
New Zealand
New Zealand was the first central bank to begin inflation targeting in February of 1990. New Zealand was experiencing high inflation rates in the 1980s, both in relative terms and absolute terms. Previously, New Zealand tried to fight inflation by exercising a freeze on virtually everything that had a price: rents, wages, fees, and interest rates. Unfortunately, these policies were extremely ineffective, which eventually led to a political change. The Labour Party took control of the country in 1984 and approached the inflation similar to a hydra--attack the source, not the head.[4] Over the years New Zealand gained substantial ground in price stability, as depicted by the graph below, and in 1991 inflation fell below 2 percent.[5]
It is easy to come to the conclusion that inflation targeting solved New Zealand's inflationary crisis; however, a glance behind the scenes shows two other factors that may have helped increase price stability. New Zealand's government began to take a much tougher stance in regards to macroeconomic policies, willing to pass reform across all sectors of its economy. New Zealand's trading partners began to see inflation decrease during the same period as well, aiding in the subsiding of inflation. Regardless, inflation targeting has helped New Zealand substantially. By creating an explicit inflation rate, the Reserve Bank of New Zealand has effectively influenced the inflation expectations of the public. Inflation targeting helps reinforce New Zealand's public rhetoric by demonstrating that both the RBNZ and the Government of New Zealand are committed to the same goal.
Canada
Canada followed New Zealand in implementing an inflation targeting monetary policy in 1991. Canada's initial objective in regards to the implementation was to reduce the inflation rate (roughly five percent at the beginning of the year) to a consistent range between 1% and 3%. The graph below is a representation of the price stability that was experienced immediately after the policy was implemented.
Like most central banks, the Central Bank of Canada struggled with building credibility as a financial regulator, something that is essential for an effective inflation target. The graph demonstrates that while the overall CPI averaged the goal of two percent, some anomalies have occurred. The deviations experienced from 1995 through 2005 are the result of price shocks that struck the Canadian economy. A comparison of the effects of these shocks on the CPI during 1995 through 2005 to the previous decades prior to inflation targeting implementation show a substantial decline in CPI fluctuation. The Central Bank of Canada links the decline in fluctuation as a result of increased flexibility by the Canadian economy through anchored inflation expectations. These expectations have been firmly established due to successful inflation target implementation.[6] Canada's success in this area of CPI targeting for inflation has become a great example for other countries dealing with similar problems. In a recent article written by Mr. Greg Quinn, it has become increasingly apparent that both Ben Bernanke (U.S. Federal Reserve Chariman) and Masaaki Shirakawa (Governor of the Bank of Japan) have been taking notes on the Canadian way to fight off deflation.[7]
United Kingdom
The United Kingdom was plagued with high inflation during the 1970s, and in the 1980s the Bank of England realized its policy of monetary targeting and currency devaluation was proving to be ineffective. The UK adopted a currency peg based on the Deutsch Mark in the late 1980s, but this policy failed miserably as well. The government lost substantial credibility in pursuing monetary policy. George Soros led the charge in speculation against the U.K., which eventually caused the peg to collapse in September of 1992. Below is a graphical representation of the volatility of inflation, measured in Retail Price Index.[8]
The graph above shows the volatility that the United Kingdom experienced while attempting to utilize monetary targeting and a currency peg. The slight increase shortly following 1990 demonstrates the collapse of the peg. After inflation targeting had been implemented in 1992, as in most cases, the U.K. experienced substantially less volatility. The Central Bank of London works closely with the government in establishing a system of checks and balances. The government is the entity that sets the inflation target, not the Central Bank. Whenever the inflation target is missed by more than one percentage point, the Governor of the Central Bank must write a letter to the Chancellor of the Exchequer (the equivalent to Treasury Secretary Timothy Geithner) explaining why the target was not met. Every year the Chancellor announces the inflation target.[9] In 2003, then Chancellor Gordan Brown announced the inflation target would be lowered from 2.5% to 2%, and data would be based on the Harmonised Index of Consumer Prices (HICP) instead of RPIX, which is the same index used by the European Central Bank.
The HICP allows the Central Bank of London to measure how well the U.K. economy is faring in contrast to the rest of Europe. Many viewed this measurement change was preparation for the U.K. to join the European Union and adopt the euro, but that was disproved by Gordon Brown's statement on December 10, 2003.[10] The graph above shows the difference between the RPIX and the HICP.
Emerging Economies and Explicit Inflation Targeting
South Korea
One word can sum up South Korea's goal for their economy: stability: The BOK has one primary goal as far as their monetary policy is concerned. They wish to keep prices stable. This goal is actually written in the Bank of Korea Act that came in to effect in April 1998. Economic and financial stability are secondary goals they also strive to reach. Their inflation target is set according to the decision of the BOK and the Korean government. Until 2003, they set their target and re-evaluated it on an annual basis. In 2004, they decided to change their target every 2 years instead.
Now, South Korea doesn't use a specific point target. Instead, they pick a range to hold their inflation rate for the period. This range is adjusted for the next term by the Monetary Policy Committee. They set this range by using inflation forecasting models and the call money market rate. The call money market rate is the interest rate that banks charge to brokers to finance margin loans to brokers. Until 2002, the range was +/- 1% of their projected target. In 2002, they decided to tighten the range to +/- 0.5%. Specifically, from 2004-2006 and 2007-2009 the range was 2.5% +/- 0.5%. After deciding their final monetary policy decision, the BOK is very transparent to their own society. They announce the intention to the public immediately and submit an annual report on monetary policy to the National Assembly. This really helps their bank maintain discipline, transparency and accountability. It also boosts the amount of trust that the society puts in their national bank and Monetary Policy Committee.
The reason for their shift to a more explicit inflation target is simple: the Asian financial crisis. In the wake of the crisis that hit Asia, South Korea was facing severe macroeconomic and financial instability. As mentioned earlier, their main goal of operations is stability, so naturally it was time for a change. There was a struggle between solving the recession and keeping inflation in control, as well as a weakening currency. Their target helped to reign in the inflation and increase their overall macroeconomic and financial stability. The graph below depicts their inflation rates before, during and after the Asian crisis. It is obvious that their inflation range was effective.[11]
Chile
Chile was one of the first emerging markets to implement an explicit and publicly announced annual inflation target in September of 1990. Their move to and explicit IT was in response to expansionary policies adopted by the country the year before as well as a temporary oil price shock associated with the Gulf War that was going on in 1990. Their adoption of an IT as the nominal anchor for the economy was paired with a tightening of monetary policy. They use the headline CPI is used by Chile as the relevant index for judging what target to shoot for. As of 2001, they opted for a stationary annual inflation target range of 2%-4% per year. When they first adopted an inflation target, they also used a range as their target. Between those two points in time, Chile adopted point targets to reduce pressures of an unclear signal to the public and a weak commitment to the full range.[12]
Chile is a great success story for those supporters of an inflation target. The graph below shows their inflation levels before and after they implemented an explicit inflation target. The change is excessively obvious. Chile's financial crisis of 1982 also affected their policies and inflation. Chile's response to these conditions included repo agreements, nationalizing banks, and various other emergency tactics.[13] Their worst levels were from 1925 right up to 1989, which brings us right to where they implement the inflation target. Their target is announced ever September and runs annually from December - December. In order to monitor their inflation levels, they compile inflation reports every four months. To increase transparency, they release the minutes of the meeting three weeks after the meeting takes place and all meetings are announced prior to commencement. They have gained the trust of their country through this transparency and the obvious results they've had by using the target.[14]
Brazil
Brazil adopted an inflation target after they experienced the 1998 balance-of-payments crisis and subsequent depreciation of their currency, the Brazilian real. In March of 1999, a new board was appointed to the Central Bank of Brazil. They sketched out a framework based on two important goals: containing the pass-through from devaluation to inflation and control inflation targets. They tried to achieve this by restricting monetary policy, changing to a "dirty float" exchange rate regime and implementing an inflation target. The graph below outlines the inflation of Brazil in the past thirty years. It is apparent where they fell into disarray, as well as how effective the inflation target was and still is for their country.
Their inflation target followed British and Swedish ideals and experiences. they were able to adopt the policy and fully implement it all within four months, which is a very quick turnaround compared to most countries that decide to implement an inflation target. In July of 1999 they began their fight against rising inflation. They announced a multi-year annual inflation target system, beginning at 8% and aiming for 4% in 2001. They also allowed a 2% tolerance band, or range, for the rate to float between. Again, transparency was vital to their policy. They regularly publicized their meetings and even distributed an inflation report, schedule of its future meetings and minutes of meetings within a week of being held. They also had an interesting policy of handling a breach of the target. If such a breach occurs, the Governor must present "an open letter to the Minister of Finance addressing the reasons behind the breach and the measures taken to reverse the deviation." This public "slap on the wrist" adds personal incentive to make sure the target holds.[16]
Brazil's inflation levels have decreased up until the point of 2009 and 2010, where they saw a small increase. Their target for the year 2011 is 4.5%. They are currently holding at 4.2% for this year, so reaching this goal should be realistic for their future.
Implicit Inflation Targeting
European Central Bank The graph below shows how the European Central Bank attempts to maintain price stability through both interest rates set by the bank and market expectations. The ECB does not "officially" implement an explicit inflation targeting policy, but in justifying its current monetary policy the ECB gives several reasons why it operates in its current fashion. The ECB states, "All these positive features of the definition were even further enhanced by the clarification of the Governing Council that it aims, within the definition, at inflation rates of close to 2%."[17] Thus, if it looks like a duck, quacks like a duck, then they are more likely than not practicing inflation targeting.
Turkey A more modern example of inflation targeting implementation is Turkey. In 2001, Turkey experienced the worst economic crisis in the country's history, which was the result of a stabilization policy aimed at pegging the Lira's exchange rate. Turkey underwent major reform to stabilize the torn country. The central bank began toying with the idea of inflation targeting by announcing it will begin implicit inflation targeting in 2002. This announcement was viewed with skepticism since Turkey was in an extremely volatile state before implementation. National debt had reached 90.5 percent of GNP. Nearly 40 percent of all the assets on the CBT balance sheet were valued in a foreign currency.[19] The substantial exposure of the country to numerous risks caused the risk premium to be very high, but began to fall during the implicit inflation targeting as demonstrated in the graph below.
The key factor that aided in the success of Turkey's inflation targeting was the complete independence of the central bank. The CBT had complete authority over deciding what monetary policy the bank would pursue, but was also required to be completely transparent with the public in regards to its pursuit of inflation rates. The implicit inflation targeting implementation was rough in the beginning; inefficient communication regarding inflation expectations and inability to forecast and control inflation hindered the CBT's ability to establish the credibility required for inflation targeting to be substantially effective. Defying all odds, the results were essentially immediate: inflation hovered just below 70% in 2001, then fell to 30% in 2002 and 18% in 2003. Turkey even experienced single-digit inflation of 7.7% in 2005.[20]
United States
Although the Federal Reserve currently rejects any explicit affiliation with inflation targeting, it has been influenced by many of the same ideas that have influenced self-described inflation targeters. The Federal Reserve implements a more implicit inflation target. For example, over the past twenty years, the Federal Reserve, has greatly increased its credibility for maintaining low and stable inflation, has become more proactive in heading off inflationary pressures, and has worked hard to improve the transparency of its policymaking process, all characteristics of the inflation-targeting approach, without actually announcing a specific targeted rate. Federal Reserve Chairman, Ben Bernanke commented, "Personally, though, I believe that U.S. monetary policy would be better in the long run if the Fed chose to make its policy framework somewhat more explicit. making the Fed's inflation goals and its medium-term projections for the economy more explicit would reduce uncertainty and assist planning in financial markets and in the economy more generally." [21]
B. Benefits and Costs of Inflation Targeting
As of 2006, twenty-two countries have formally adopted inflation targeting. Although there are many skeptics, inflation targeting has many benefits. Many advocates for inflation targeting reside in the United States and base their view on the economic benefits of a low, stable level of inflation.[22]
The goals of monetary policy vary across central banks. The Federal Reserve, for example, lists it monetary policy goals as "to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates". The European Central Bank lists price stability as its primary objective. There are also central banks whose monetary policy centers on exchange rate stability.[23] Because not all central banks that state price stability among their goals of monetary policy have chosen an inflation targeting framework, it is indicative that it is not clear whether the benefits of inflation targeting exceeds its costs.[24]
Economists widely agree that a low, steady inflation rate is best for economic growth. As mentioned in the United States' section, Mr. Bernanke had called for the Fed to officially announce an inflation target -- say, 2 percent or slightly less -- when he was an economics professor. Such a target, like those used by the central banks in Britain, Canada, and elsewhere, could enhance transparency and predictability. But opponents say it could restrict the Fed's flexibility, forcing it to stick with a target even in the face of an external shock to the economy.[25]
The benefits of inflation targeting are many. Two of the prominent benefits of inflation targeting are enhancement of transparency and reduction of price variability. The inflation targeting strategy promotes convergence in forecasting errors. It has observed that the countries that adopted inflation targeting are getting greater gains than the rest of the countries in the world. It has also observed that the countries adopted a numerical inflation target and succeeded in maintaining a low inflation rate. Other most important benefits of using inflation targeting include enhanced public understanding of monetary policy, increased central bank accountability, and an improved state for economic growth. [26]
Benefits of Inflation Targeting (IT) The most important benefit of inflation targeting is that it helps the central banks to maintain low inflation and low inflation eventually promotes long-term growth. Some of the numerous benefits of using inflation targeting are as follows:
In the graph above, you can see deviations in the output gap in Thailand while using inflation targeting.
Questions to Ask When Developing a Framework for Making Policy Choices
1. Which measure of inflation should be targeted?
Principally, the inflation measure should be broad-based, accurate, timely, and familiar to the general public. This measure should exclude price changes in sectors that are volatile and where fluctuations are not likely to affect trend or "core" inflation." It is also good to reassure the public that the central bank is not manipulating inflation data. (This can be done by utilizing data that is compiled by an agency that is independent of the central bank.)[31]
2. What Numerical Value Should the Target Have? Targeting an inflation rate that is too low or too high could create problems. An inflation target that is too low might lead to higher unemployment. Some suggest that an inflation rate close to zero could increase the long-run level of unemployment. This might restrict the central bank's ability to support a recovery in times of recession due to the zero lower bound on nominal interest rates and might increase the chances or frequency of deflation rather than inflation. Also, no one wants to have an inflation rate that is too high either, as inflation costs can be considerable. In practice, inflation targets in developed economies are usually set at 1% to 3% per year.[32]
3. What Should the Time Horizon be to (approximately) Hit the Target? Time horizons of less than one year or greater than four years are likely to be problematic. Monetary policy has considerable internal time lags, and, therefore, is likely to have difficulty affecting inflation over a short horizon as one year or less. On the other hand, targets that are as distant as four years into the future might not be viewed by the public as being very credible. Still, there are plenty of time horizon choices between the one to four year range.[33]
One Strategy for Communicating Guidelines of the Inflation Targeting Regime Communication is a major theme in inflation targeting. Increased communication is better likely to anchor inflation expectations if the public trusts that the central bank will achieve its stated price stability goals. The public will then price a more-stable expectation of future inflation into contracts and asset prices. In this way, anchored inflation expectations make it easier for the cental bank to keep actual inflation stable, and deliver on its price stability promise.[34] Committing to an inflation rate target will limit the choices the central bank has when it comes to changes in monetary or fiscal policy.
C. Economists' Views on Inflation Targeting
As with all topics, inflation targeting brings up some opposing opinions in the world of economists. Some are in favor of the targeting plan while others clearly oppose the idea. In 2003, Michael Woodford prepared a report outlining what he perceived as the clear beneficial relationship between inflation targeting and optimal monetary policy. He acknowledges that the creation of the inflation target has often been "credited with having brought about substantial reductions in both the level and variability of inflation in the inflation-targeting countries, and is sometimes argued to have improved the stability of the real economy as well." He identifies the definite advantages of having an explicit target for monetary policy. Woodford claims that the most beneficial part of having an inflation target is actually not the target itself, but more "the development of an approach to the conduct of policy that focuses on a clearly defined target, that assigns an important role to quantitative projects of the economy's future evolution in policy decisions, and that is committed to a high degree of transparency as to the goals of policy, the decisions that are made, and the principles that guide those decisions." His paper continues on, explaining his support for an explicit target as well as the successes of an inflation target.[35]
As former chairmen of the Federal Reserve, Alan Greenspan had a heavy influence on our economy before the current chairmen, Ben Bernanke. They differed on some topics, including the implementation of an inflation target. Mr. Greenspan consistently spoke against implementing an explicit inflation target, claiming that “[c]hoosing a specific inflation target for the Federal Reserve to meet would not help the central bank set interest rates.” He claimed that an inflation target would not help because of the rising degree of difficulty in calculating the inflation rate. “A specific numerical inflation target would represent an unhelpful and false precision.” Where critics call for inflation targets to increase price stability, Mr. Greenspan also disagrees. He has a different definition of price stability, one where the idea of inflation wouldn’t even cross the minds of households and firms when making a decision. This dismissal of inflation would be caused due to the fact that the amount of inflation is so stable that it simply doesn’t matter.[36]
The other debate involving an inflation target, whether explicit or implicit, is where to set the target at. There are supporters of both a high target and a low target. Many economists support a low and steady inflation rate because they believe that it is best for any form of economic growth. Even current chairman Ben Bernanke called for an announced inflation target of 2% or lower to further enhance transparency and predictability of the Fed's actions.[37]
There are also those who call for more drastic changes. One such economist, Mr. Ken Rogoff, has been quoted calling for more drastic changes to inflation. "[I]t is time for the world's major central banks to acknowledge that a sudden burst of moderate inflation would be extremely helpful in unwinding today's epic morass." He has called for moderate inflation (about 6%) for a short amount of time. While it wouldn't be a complete and instant fix, it would simply make other steps less costly and even more effective. Other economists, such as Oliver Blanchard (Chief Economist of the IMF) and Paul Krugman (Nobel Prize winner in economics) are calling for higher inflation. Unfortunately, these men aren't the ones actually in charge of setting monetary policy. They can only voice their opinions and hope that they have an influence on someone.[38]
D. To Target, or Not to Target?
Each country's central bank, and each individual for that matter has their own opinion of an inflation targeting policy. As already mentioned, some favor such monetary policy, while others are in opposition of the idea. While studies have generally established a link between the practice of inflation targeting and improved economic performance, they have yet to proven a positive relationship amongst the two. Furthermore, stable and mature non-targeting nations, including the United States, have often done just as well or better without implementing inflation targeting in their monetary policy.[39]
Economists often argue that it does not matter whether central banks announce inflation targets, they all use them, whether explicit or implicit. For example, the United States Federal Reserve seems to have an implicit inflation target of around 1-2 percent; it tightens policy when inflation rises above this level and will loosen it when inflation falls (the same way it would respond if an explicit target had been adopted.[40] Although inflation targeting provides a general framework for conducting monetary policy, it does not offer a “one-size-fits-all” prescription. There is considerable variation among inflation-targeting central banks' implementation of the framework.[41]
Economic performance varies greatly across individual countries, both targeters and non-targeters. However, again, there is no evidence that inflation targeting improves performance as measured by the behavior of inflation, output or interest rates. One study, published in 2005, found that from examining inflation-targeting countries alone, you can conclude that their performance improved on average between the period before targeting and the period after targeting. However, countries that did not adopt an explicit inflation target also experienced improvements around the same times as targeters. This suggests that improved economic performance resulted from something other than inflation targeting. The table below displays these findings.[42]
The question of whether a central bank should adopt an inflation targeting policy brings to light several issues. While inflation targeting encourages greater central bank transparency, which helps resolve some political issues, influence inflation expectations, helps policy makers control long-term interest rates, and allows the central bank to commit to long-term price stability, there are downsides to adopting this monetary policy, as mentioned in section B.[43]When condsidering inflation targeting as a monetary policy there are often some common misconceptions made:Misconception #1: Inflation targeting involves mechanical, rule-like policymaking. Inflation targeting is a policy framework, not a rule. But making monetary policy under inflation targeting requires as much insight and judgment as under any policy framework; indeed, inflation targeting can be particularly demanding in that it requires policymakers to give careful, fact-based, and analytical explanations of their actions to the public.
Misconception #2: Inflation targeting focuses exclusively on control of inflation and ignores output and employment objectives. Many economists have made a distinctiong between "strict" inflation targeting, in which the only objective of the central bank is price stability, and "flexible" inflation targeting, which allows attention to output and employment as well. However, Federal Reserve chairman, Ben Bernanke commented,"I am not aware of any real-world central bank (the language of its mandate notwithstanding) that does not treat the stabilization of employment and output as an important policy objective." Bernanke strongly believes that all inflation targeting policies today are flexible.Misconception #3: Inflation targeting is inconsistent with the central bank's obligation to maintain financial stability. Again, Ben Bernanke argues that, 'I see no conflict between that role and inflation targeting (indeed, inflation targeting seems to require the preservation of financial stability as part of preserving macroeconomic stability), and I have never heard a proponent of inflation targeting argue otherwise." [44]In conclusion, whether or not a central bank chooses to implement inflation targeting or decides to use some other framework, there is no reason to believe the policy will necessarily harm an economy, or allow it prosper. Choosing such a policy is up to each individual central bank.
An inflation target policy is utilized when a central bank announces an objective for the inflation rate, usually in a time line of one to three years.[1]
A. Central Banks and Inflation Targeting
Inflation targeting has only been around for twenty years, allowing many to still speculate on the beneficial effects of such a policy. There are many distortions as to whether or not a particular central bank is explicitly enforcing inflation targeting or applying the same procedures required under inflation targeting, but simply call it another name. There never is an exact number of countries that employ inflation targeting as many more central banks begin to adopt the policy or consider adopting it.[2] This section gives a brief overview of a few countries that have implemented inflation targeting and their experience with the policy thus far. The first section provides an overview of how banks practice explicit inflation targeting and their respective results, followed by an overview of central banks practicing implicit inflation targeting. Below is a list of central banks currently employing an explicit inflation targeting monetary policy.
The graph above gives an example of a few countries, both advanced and emerging, that currently implement an inflation target. It depicts the range in which they let it sit in, or, in the case of some, the point target they are trying to achieve. In the next section, we will discuss the implementation of an inflation target in various countries, both advanced and emerging, as well as those that implement an in implicit target.
Industrial Economies and Explicit Inflation Targeting
New Zealand
New Zealand was the first central bank to begin inflation targeting in February of 1990. New Zealand was experiencing high inflation rates in the 1980s, both in relative terms and absolute terms. Previously, New Zealand tried to fight inflation by exercising a freeze on virtually everything that had a price: rents, wages, fees, and interest rates. Unfortunately, these policies were extremely ineffective, which eventually led to a political change. The Labour Party took control of the country in 1984 and approached the inflation similar to a hydra--attack the source, not the head.[4] Over the years New Zealand gained substantial ground in price stability, as depicted by the graph below, and in 1991 inflation fell below 2 percent.[5]
It is easy to come to the conclusion that inflation targeting solved New Zealand's inflationary crisis; however, a glance behind the scenes shows two other factors that may have helped increase price stability. New Zealand's government began to take a much tougher stance in regards to macroeconomic policies, willing to pass reform across all sectors of its economy. New Zealand's trading partners began to see inflation decrease during the same period as well, aiding in the subsiding of inflation. Regardless, inflation targeting has helped New Zealand substantially. By creating an explicit inflation rate, the Reserve Bank of New Zealand has effectively influenced the inflation expectations of the public. Inflation targeting helps reinforce New Zealand's public rhetoric by demonstrating that both the RBNZ and the Government of New Zealand are committed to the same goal.
Canada
Canada followed New Zealand in implementing an inflation targeting monetary policy in 1991. Canada's initial objective in regards to the implementation was to reduce the inflation rate (roughly five percent at the beginning of the year) to a consistent range between 1% and 3%. The graph below is a representation of the price stability that was experienced immediately after the policy was implemented.
Like most central banks, the Central Bank of Canada struggled with building credibility as a financial regulator, something that is essential for an effective inflation target. The graph demonstrates that while the overall CPI averaged the goal of two percent, some anomalies have occurred. The deviations experienced from 1995 through 2005 are the result of price shocks that struck the Canadian economy. A comparison of the effects of these shocks on the CPI during 1995 through 2005 to the previous decades prior to inflation targeting implementation show a substantial decline in CPI fluctuation. The Central Bank of Canada links the decline in fluctuation as a result of increased flexibility by the Canadian economy through anchored inflation expectations. These expectations have been firmly established due to successful inflation target implementation.[6] Canada's success in this area of CPI targeting for inflation has become a great example for other countries dealing with similar problems. In a recent article written by Mr. Greg Quinn, it has become increasingly apparent that both Ben Bernanke (U.S. Federal Reserve Chariman) and Masaaki Shirakawa (Governor of the Bank of Japan) have been taking notes on the Canadian way to fight off deflation.[7]
United Kingdom
The United Kingdom was plagued with high inflation during the 1970s, and in the 1980s the Bank of England realized its policy of monetary targeting and currency devaluation was proving to be ineffective. The UK adopted a currency peg based on the Deutsch Mark in the late 1980s, but this policy failed miserably as well. The government lost substantial credibility in pursuing monetary policy. George Soros led the charge in speculation against the U.K., which eventually caused the peg to collapse in September of 1992. Below is a graphical representation of the volatility of inflation, measured in Retail Price Index.[8]
The graph above shows the volatility that the United Kingdom experienced while attempting to utilize monetary targeting and a currency peg. The slight increase shortly following 1990 demonstrates the collapse of the peg. After inflation targeting had been implemented in 1992, as in most cases, the U.K. experienced substantially less volatility. The Central Bank of London works closely with the government in establishing a system of checks and balances. The government is the entity that sets the inflation target, not the Central Bank. Whenever the inflation target is missed by more than one percentage point, the Governor of the Central Bank must write a letter to the Chancellor of the Exchequer (the equivalent to Treasury Secretary Timothy Geithner) explaining why the target was not met. Every year the Chancellor announces the inflation target.[9] In 2003, then Chancellor Gordan Brown announced the inflation target would be lowered from 2.5% to 2%, and data would be based on the Harmonised Index of Consumer Prices (HICP) instead of RPIX, which is the same index used by the European Central Bank.
The HICP allows the Central Bank of London to measure how well the U.K. economy is faring in contrast to the rest of Europe. Many viewed this measurement change was preparation for the U.K. to join the European Union and adopt the euro, but that was disproved by Gordon Brown's statement on December 10, 2003.[10] The graph above shows the difference between the RPIX and the HICP.
Emerging Economies and Explicit Inflation Targeting
South Korea
One word can sum up South Korea's goal for their economy: stability: The BOK has one primary goal as far as their monetary policy is concerned. They wish to keep prices stable. This goal is actually written in the Bank of Korea Act that came in to effect in April 1998. Economic and financial stability are secondary goals they also strive to reach. Their inflation target is set according to the decision of the BOK and the Korean government. Until 2003, they set their target and re-evaluated it on an annual basis. In 2004, they decided to change their target every 2 years instead.
Now, South Korea doesn't use a specific point target. Instead, they pick a range to hold their inflation rate for the period. This range is adjusted for the next term by the Monetary Policy Committee. They set this range by using inflation forecasting models and the call money market rate. The call money market rate is the interest rate that banks charge to brokers to finance margin loans to brokers. Until 2002, the range was +/- 1% of their projected target. In 2002, they decided to tighten the range to +/- 0.5%. Specifically, from 2004-2006 and 2007-2009 the range was 2.5% +/- 0.5%. After deciding their final monetary policy decision, the BOK is very transparent to their own society. They announce the intention to the public immediately and submit an annual report on monetary policy to the National Assembly. This really helps their bank maintain discipline, transparency and accountability. It also boosts the amount of trust that the society puts in their national bank and Monetary Policy Committee.
The reason for their shift to a more explicit inflation target is simple: the Asian financial crisis. In the wake of the crisis that hit Asia, South Korea was facing severe macroeconomic and financial instability. As mentioned earlier, their main goal of operations is stability, so naturally it was time for a change. There was a struggle between solving the recession and keeping inflation in control, as well as a weakening currency. Their target helped to reign in the inflation and increase their overall macroeconomic and financial stability. The graph below depicts their inflation rates before, during and after the Asian crisis. It is obvious that their inflation range was effective.[11]
Chile
Chile was one of the first emerging markets to implement an explicit and publicly announced annual inflation target in September of 1990. Their move to and explicit IT was in response to expansionary policies adopted by the country the year before as well as a temporary oil price shock associated with the Gulf War that was going on in 1990. Their adoption of an IT as the nominal anchor for the economy was paired with a tightening of monetary policy. They use the headline CPI is used by Chile as the relevant index for judging what target to shoot for. As of 2001, they opted for a stationary annual inflation target range of 2%-4% per year. When they first adopted an inflation target, they also used a range as their target. Between those two points in time, Chile adopted point targets to reduce pressures of an unclear signal to the public and a weak commitment to the full range.[12]
Chile is a great success story for those supporters of an inflation target. The graph below shows their inflation levels before and after they implemented an explicit inflation target. The change is excessively obvious. Chile's financial crisis of 1982 also affected their policies and inflation. Chile's response to these conditions included repo agreements, nationalizing banks, and various other emergency tactics.[13] Their worst levels were from 1925 right up to 1989, which brings us right to where they implement the inflation target. Their target is announced ever September and runs annually from December - December. In order to monitor their inflation levels, they compile inflation reports every four months. To increase transparency, they release the minutes of the meeting three weeks after the meeting takes place and all meetings are announced prior to commencement. They have gained the trust of their country through this transparency and the obvious results they've had by using the target.[14]
Brazil
Brazil adopted an inflation target after they experienced the 1998 balance-of-payments crisis and subsequent depreciation of their currency, the Brazilian real. In March of 1999, a new board was appointed to the Central Bank of Brazil. They sketched out a framework based on two important goals: containing the pass-through from devaluation to inflation and control inflation targets. They tried to achieve this by restricting monetary policy, changing to a "dirty float" exchange rate regime and implementing an inflation target. The graph below outlines the inflation of Brazil in the past thirty years. It is apparent where they fell into disarray, as well as how effective the inflation target was and still is for their country.
Their inflation target followed British and Swedish ideals and experiences. they were able to adopt the policy and fully implement it all within four months, which is a very quick turnaround compared to most countries that decide to implement an inflation target. In July of 1999 they began their fight against rising inflation. They announced a multi-year annual inflation target system, beginning at 8% and aiming for 4% in 2001. They also allowed a 2% tolerance band, or range, for the rate to float between. Again, transparency was vital to their policy. They regularly publicized their meetings and even distributed an inflation report, schedule of its future meetings and minutes of meetings within a week of being held. They also had an interesting policy of handling a breach of the target. If such a breach occurs, the Governor must present "an open letter to the Minister of Finance addressing the reasons behind the breach and the measures taken to reverse the deviation." This public "slap on the wrist" adds personal incentive to make sure the target holds.[16]
Brazil's inflation levels have decreased up until the point of 2009 and 2010, where they saw a small increase. Their target for the year 2011 is 4.5%. They are currently holding at 4.2% for this year, so reaching this goal should be realistic for their future.
Implicit Inflation Targeting
European Central Bank
The graph below shows how the European Central Bank attempts to maintain price stability through both interest rates set by the bank and market expectations. The ECB does not "officially" implement an explicit inflation targeting policy, but in justifying its current monetary policy the ECB gives several reasons why it operates in its current fashion. The ECB states, "All these positive features of the definition were even further enhanced by the clarification of the Governing Council that it aims, within the definition, at inflation rates of close to 2%."[17] Thus, if it looks like a duck, quacks like a duck, then they are more likely than not practicing inflation targeting.
Turkey
A more modern example of inflation targeting implementation is Turkey. In 2001, Turkey experienced the worst economic crisis in the country's history, which was the result of a stabilization policy aimed at pegging the Lira's exchange rate. Turkey underwent major reform to stabilize the torn country. The central bank began toying with the idea of inflation targeting by announcing it will begin implicit inflation targeting in 2002. This announcement was viewed with skepticism since Turkey was in an extremely volatile state before implementation. National debt had reached 90.5 percent of GNP. Nearly 40 percent of all the assets on the CBT balance sheet were valued in a foreign currency.[19] The substantial exposure of the country to numerous risks caused the risk premium to be very high, but began to fall during the implicit inflation targeting as demonstrated in the graph below.
The key factor that aided in the success of Turkey's inflation targeting was the complete independence of the central bank. The CBT had complete authority over deciding what monetary policy the bank would pursue, but was also required to be completely transparent with the public in regards to its pursuit of inflation rates. The implicit inflation targeting implementation was rough in the beginning; inefficient communication regarding inflation expectations and inability to forecast and control inflation hindered the CBT's ability to establish the credibility required for inflation targeting to be substantially effective. Defying all odds, the results were essentially immediate: inflation hovered just below 70% in 2001, then fell to 30% in 2002 and 18% in 2003. Turkey even experienced single-digit inflation of 7.7% in 2005.[20]
United States
Although the Federal Reserve currently rejects any explicit affiliation with inflation targeting, it has been influenced by many of the same ideas that have influenced self-described inflation targeters. The Federal Reserve implements a more implicit inflation target. For example, over the past twenty years, the Federal Reserve, has greatly increased its credibility for maintaining low and stable inflation, has become more proactive in heading off inflationary pressures, and has worked hard to improve the transparency of its policymaking process, all characteristics of the inflation-targeting approach, without actually announcing a specific targeted rate. Federal Reserve Chairman, Ben Bernanke commented, "Personally, though, I believe that U.S. monetary policy would be better in the long run if the Fed chose to make its policy framework somewhat more explicit. making the Fed's inflation goals and its medium-term projections for the economy more explicit would reduce uncertainty and assist planning in financial markets and in the economy more generally." [21]
B. Benefits and Costs of Inflation Targeting
As of 2006, twenty-two countries have formally adopted inflation targeting. Although there are many skeptics, inflation targeting has many benefits. Many advocates for inflation targeting reside in the United States and base their view on the economic benefits of a low, stable level of inflation.[22]
The goals of monetary policy vary across central banks. The Federal Reserve, for example, lists it monetary policy goals as "to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates". The European Central Bank lists price stability as its primary objective. There are also central banks whose monetary policy centers on exchange rate stability.[23] Because not all central banks that state price stability among their goals of monetary policy have chosen an inflation targeting framework, it is indicative that it is not clear whether the benefits of inflation targeting exceeds its costs.[24]
Economists widely agree that a low, steady inflation rate is best for economic growth. As mentioned in the United States' section, Mr. Bernanke had called for the Fed to officially announce an inflation target -- say, 2 percent or slightly less -- when he was an economics professor. Such a target, like those used by the central banks in Britain, Canada, and elsewhere, could enhance transparency and predictability. But opponents say it could restrict the Fed's flexibility, forcing it to stick with a target even in the face of an external shock to the economy.[25]
The benefits of inflation targeting are many. Two of the prominent benefits of inflation targeting are enhancement of transparency and reduction of price variability. The inflation targeting strategy promotes convergence in forecasting errors. It has observed that the countries that adopted inflation targeting are getting greater gains than the rest of the countries in the world. It has also observed that the countries adopted a numerical inflation target and succeeded in maintaining a low inflation rate. Other most important benefits of using inflation targeting include enhanced public understanding of monetary policy, increased central bank accountability, and an improved state for economic growth. [26]
Benefits of Inflation Targeting (IT)
The most important benefit of inflation targeting is that it helps the central banks to maintain low inflation and low inflation eventually promotes long-term growth. Some of the numerous benefits of using inflation targeting are as follows:
Inflation targeting is an effective monetary policy, which provides a better nominal anchor for monetary policy and inflation expectations.
Significant Benefits of Inflation Targeting
Inflation targeting enables the central banks to set long-run inflation objectives. Some of the most significant benefits of inflation targeting are:
Emperical Benefits of Inflation Targeting
Costs
If inflation targeting were implemented as a very strict policy rule, then it could have some serious costs.
In the graph above, you can see deviations in the output gap in Thailand while using inflation targeting.
Questions to Ask When Developing a Framework for Making Policy Choices
1. Which measure of inflation should be targeted?
Principally, the inflation measure should be broad-based, accurate, timely, and familiar to the general public. This measure should exclude price changes in sectors that are volatile and where fluctuations are not likely to affect trend or "core" inflation." It is also good to reassure the public that the central bank is not manipulating inflation data. (This can be done by utilizing data that is compiled by an agency that is independent of the central bank.)[31]
2. What Numerical Value Should the Target Have?
Targeting an inflation rate that is too low or too high could create problems. An inflation target that is too low might lead to higher unemployment. Some suggest that an inflation rate close to zero could increase the long-run level of unemployment. This might restrict the central bank's ability to support a recovery in times of recession due to the zero lower bound on nominal interest rates and might increase the chances or frequency of deflation rather than inflation. Also, no one wants to have an inflation rate that is too high either, as inflation costs can be considerable. In practice, inflation targets in developed economies are usually set at 1% to 3% per year.[32]
3. What Should the Time Horizon be to (approximately) Hit the Target?
Time horizons of less than one year or greater than four years are likely to be problematic. Monetary policy has considerable internal time lags, and, therefore, is likely to have difficulty affecting inflation over a short horizon as one year or less. On the other hand, targets that are as distant as four years into the future might not be viewed by the public as being very credible. Still, there are plenty of time horizon choices between the one to four year range.[33]
One Strategy for Communicating Guidelines of the Inflation Targeting Regime
Communication is a major theme in inflation targeting. Increased communication is better likely to anchor inflation expectations if the public trusts that the central bank will achieve its stated price stability goals. The public will then price a more-stable expectation of future inflation into contracts and asset prices. In this way, anchored inflation expectations make it easier for the cental bank to keep actual inflation stable, and deliver on its price stability promise.[34] Committing to an inflation rate target will limit the choices the central bank has when it comes to changes in monetary or fiscal policy.
C. Economists' Views on Inflation Targeting
As with all topics, inflation targeting brings up some opposing opinions in the world of economists. Some are in favor of the targeting plan while others clearly oppose the idea. In 2003, Michael Woodford prepared a report outlining what he perceived as the clear beneficial relationship between inflation targeting and optimal monetary policy. He acknowledges that the creation of the inflation target has often been "credited with having brought about substantial reductions in both the level and variability of inflation in the inflation-targeting countries, and is sometimes argued to have improved the stability of the real economy as well." He identifies the definite advantages of having an explicit target for monetary policy. Woodford claims that the most beneficial part of having an inflation target is actually not the target itself, but more "the development of an approach to the conduct of policy that focuses on a clearly defined target, that assigns an important role to quantitative projects of the economy's future evolution in policy decisions, and that is committed to a high degree of transparency as to the goals of policy, the decisions that are made, and the principles that guide those decisions." His paper continues on, explaining his support for an explicit target as well as the successes of an inflation target.[35]
As former chairmen of the Federal Reserve, Alan Greenspan had a heavy influence on our economy before the current chairmen, Ben Bernanke. They differed on some topics, including the implementation of an inflation target. Mr. Greenspan consistently spoke against implementing an explicit inflation target, claiming that “[c]hoosing a specific inflation target for the Federal Reserve to meet would not help the central bank set interest rates.” He claimed that an inflation target would not help because of the rising degree of difficulty in calculating the inflation rate. “A specific numerical inflation target would represent an unhelpful and false precision.” Where critics call for inflation targets to increase price stability, Mr. Greenspan also disagrees. He has a different definition of price stability, one where the idea of inflation wouldn’t even cross the minds of households and firms when making a decision. This dismissal of inflation would be caused due to the fact that the amount of inflation is so stable that it simply doesn’t matter.[36]
The other debate involving an inflation target, whether explicit or implicit, is where to set the target at. There are supporters of both a high target and a low target. Many economists support a low and steady inflation rate because they believe that it is best for any form of economic growth. Even current chairman Ben Bernanke called for an announced inflation target of 2% or lower to further enhance transparency and predictability of the Fed's actions.[37]
There are also those who call for more drastic changes. One such economist, Mr. Ken Rogoff, has been quoted calling for more drastic changes to inflation. "[I]t is time for the world's major central banks to acknowledge that a sudden burst of moderate inflation would be extremely helpful in unwinding today's epic morass." He has called for moderate inflation (about 6%) for a short amount of time. While it wouldn't be a complete and instant fix, it would simply make other steps less costly and even more effective. Other economists, such as Oliver Blanchard (Chief Economist of the IMF) and Paul Krugman (Nobel Prize winner in economics) are calling for higher inflation. Unfortunately, these men aren't the ones actually in charge of setting monetary policy. They can only voice their opinions and hope that they have an influence on someone.[38]
D. To Target, or Not to Target?
Each country's central bank, and each individual for that matter has their own opinion of an inflation targeting policy. As already mentioned, some favor such monetary policy, while others are in opposition of the idea. While studies have generally established a link between the practice of inflation targeting and improved economic performance, they have yet to proven a positive relationship amongst the two. Furthermore, stable and mature non-targeting nations, including the United States, have often done just as well or better without implementing inflation targeting in their monetary policy.[39]
Economists often argue that it does not matter whether central banks announce inflation targets, they all use them, whether explicit or implicit. For example, the United States Federal Reserve seems to have an implicit inflation target of around 1-2 percent; it tightens policy when inflation rises above this level and will loosen it when inflation falls (the same way it would respond if an explicit target had been adopted.[40] Although inflation targeting provides a general framework for conducting monetary policy, it does not offer a “one-size-fits-all” prescription. There is considerable variation among inflation-targeting central banks' implementation of the framework.[41]
Economic performance varies greatly across individual countries, both targeters and non-targeters. However, again, there is no evidence that inflation targeting improves performance as measured by the behavior of inflation, output or interest rates. One study, published in 2005, found that from examining inflation-targeting countries alone, you can conclude that their performance improved on average between the period before targeting and the period after targeting. However, countries that did not adopt an explicit inflation target also experienced improvements around the same times as targeters. This suggests that improved economic performance resulted from something other than inflation targeting. The table below displays these findings.[42]
The question of whether a central bank should adopt an inflation targeting policy brings to light several issues. While inflation targeting encourages greater central bank transparency, which helps resolve some political issues, influence inflation expectations, helps policy makers control long-term interest rates, and allows the central bank to commit to long-term price stability, there are downsides to adopting this monetary policy, as mentioned in section B.[43]When condsidering inflation targeting as a monetary policy there are often some common misconceptions made:Misconception #1: Inflation targeting involves mechanical, rule-like policymaking. Inflation targeting is a policy framework, not a rule. But making monetary policy under inflation targeting requires as much insight and judgment as under any policy framework; indeed, inflation targeting can be particularly demanding in that it requires policymakers to give careful, fact-based, and analytical explanations of their actions to the public.
Misconception #2: Inflation targeting focuses exclusively on control of inflation and ignores output and employment objectives. Many economists have made a distinctiong between "strict" inflation targeting, in which the only objective of the central bank is price stability, and "flexible" inflation targeting, which allows attention to output and employment as well. However, Federal Reserve chairman, Ben Bernanke commented,"I am not aware of any real-world central bank (the language of its mandate notwithstanding) that does not treat the stabilization of employment and output as an important policy objective." Bernanke strongly believes that all inflation targeting policies today are flexible.Misconception #3: Inflation targeting is inconsistent with the central bank's obligation to maintain financial stability. Again, Ben Bernanke argues that, 'I see no conflict between that role and inflation targeting (indeed, inflation targeting seems to require the preservation of financial stability as part of preserving macroeconomic stability), and I have never heard a proponent of inflation targeting argue otherwise." [44]In conclusion, whether or not a central bank chooses to implement inflation targeting or decides to use some other framework, there is no reason to believe the policy will necessarily harm an economy, or allow it prosper. Choosing such a policy is up to each individual central bank.
http://www.ecb.int/pub/pdf/other/monetarypolicy2004en.pdf
http://www.femise.org/activities/workshop/Papers/IT_Turkey.pdf
http://www.ilo.org/public/english/employment/download/elm/elm07-2.pdf
http://www.philadelphiafed.org/research-and-data/publications/business-review/2006/q3/br_q3-2006-2_review_inflation.pdf
http://www.frbsf.org/education/activities/drecon/answerxml.cfm?selectedurl=/2007/0703.html
http://www.nytimes.com/2010/11/24/business/economy/24fed.html?_r=1&pagewanted=all
http://www.economywatch.com/inflation/targeting/benefits.html
http://www.frbsf.org/education/activities/drecon/answerxml.cfm?selectedurl=/2007/0703.html
http://www.frbsf.org/education/activities/drecon/answerxml.cfm?selectedurl=/2007/0703.html
http://www.frbsf.org/education/activities/drecon/answerxml.cfm?selectedurl=/2007/0703.html
http://www.frbsf.org/education/activities/drecon/answerxml.cfm?selectedurl=/2007/0703.html
http://www.columbia.edu/~mw2230/StLFed.pdf
http://www.nytimes.com/2001/10/12/business/greenspan-rejects-idea-of-inflation-targets.html
http://www.nytimes.com/2010/11/24/business/economy/24fed.html
http://www.bondvigilantes.co.uk/blog/2010/03/29/1269850800000.html
http://www.nber.org/digest/septoct07/w12876.html
Money, Banking, and Financial Markets by Laurence M. Ball
http://www.econ.jhu.edu/people/ball/finalfla2.pdf